World Class Purchasing

Transcription

1 WHITEPAPER By James Ray 13 October 2016 Mission: To develop a Team to be a strategic tool that gives the business a competitive advantage in our markets by delivering the lowest cost (not price) raw materials and services possible. To begin the process of developing World Class Purchasing, you must first accept that you have a long way to go. If you cannot accept this, you cannot get there. Most manufacturing purchasing departments are understaffed with about 2-3% of the Salaried Personnel managing 65% of the companies cost of goods sold as shown in Figure 1. I always enjoy having CEO s and CFO s in my Advanced Purchasing Class when I discuss this topic. I point out that you can t afford to have a fire fighting purchasing manager going in to negotiate a multi-million dollar contract with only a few hours to plan. Figure 1 Cost of Goods Sold Breakdown The good news is that you can start from here and build a Team. To begin any process, I like to start with the end in mind. What is our Vision? So consider the following key supplier in Figure 2 who approaches you for a 5% increase despite raw material prices being stable. FIGURE 2 Key Supplier Selling You a Product Units 5,000,000 Price per unit $ 3.00 $ 1.95* Revenue $ 15,000,000 Gross Margin 35% Product Cost $ 9,750,000 Profit $ 5,250,000 * Cost/unit from our cost model Source: ICIS Purchasing Advisory Service Raw Material Cost 65% Labor, Over Head Cost, 35% I am sure most purchasing professionals have all sat at their desk as a key supplier seeks to enforce an unjustified price increase. Even worse is when it is a sole supplier and they know it.. IF we don t receive updated PO s by Friday, we will not be able to ship next week. Trust me, it happens. So let us imagine this instead. Typical Resource Allocation Other Salaried Staff 97% Raw Material Staff 3% We inform the supplier that the increase is unjustified and that he/she will immediately lose 25% of their business if they enforce such an increase, with more business loss likely later on. Because we have made similar statements in the past and followed through with them as a part of our World Class Strategy, the supplier believes we will do it. If our key supplier is smart, they will do the math (Figure 3) and realize the following outcome from an unjustified increase. IF they are not sophisticated, enough to realize this, then we must point it out to them. page 1 of 6

2 It is worth noting that the new product cost would probably be even higher with lower volume and less fixed overhead being absorbed, resulting in even less profit. However, as shown in Figure 3, if the supplier increases their price, they will end up losing $750k of profit from what they currently have. So now, what is the Key Supplier going to do? They are probably going to tell you that because you are such a good customer, they are going to absorb this increase and not pass it on to your company. In reality, it is because you have a solid purchasing strategy in place. However, we are not World Class yet. But before we take the next step, let me regress. In addition to the ICIS Purchasing Advisory Service, Advanced Purchasing Course, I also taught Increase Avoidance and in a prior role, How to pass on increases to Sales. As a part of this latter course, which was organized for the specific task of increasing prices, we were presented with a customer list that looked something like Figure 4. As a purchasing professional the last thing I want, is to be classified as Easy when it comes to passing on margin increases or negotiating a supply contract. We want to be the purchasing manager for World Class Inc. where the supplier sales people think it is near impossible to pass on an increase, especially one that is not justified. When an increase is justified, we want to verify the precise amount and not accept more than our competitors do. There are ways to achieve this, but that is beyond our scope today. So let us get back to our World Class Vision. Mr./Ms. Key Supplier, this recent request for an increase has called to our attention that your price for our product is high. Consequently, we need a 5% decrease or it will be necessary for us to move a sizeable portion of our business (Figure 5). We do not disclose the percentage this time. FIGURE 3 New volume 3,750,000 New Product Price $ 3.15 New Revenue $ 11,812,500 New Product Cost $ 7,312,500 New Profit $ 4,500,000 Profit Change $ (750,000) Source: ICIS Purchasing Advisory Service FIGURE 4 # Customer Name* Increase Difficulty 1 Rookie Inc Easy 2 Roll Over LLC Easy 3 Over loaded Corp Easy 4 Tough Nut Mfg Difficult 5 New Hire Co Easy 6 Part Timer Easy 7 Hard Case Difficult 8 World Class Inc Very Diffucult * Names Changed to protect the innocent and relect the Sales persons perception of their purchasing FIGURE 5 We have been looking at your volume: Units 5,000,000 Price per Unit $ 3.00 Revenue $ 15,000,000 Gross Margin 35% Product Cost $ 9,750,000 Profit $ 5,250,00 Now we want an decrease of 5% or a decrease of: $ 750,000 Source ICIS Advanced Purchasing Course page 2 of 6

3 Having designed the sellers three options (Figure 6), we will tell them that agreeing is their most profitable alternative. What would you do? Now we are negotiating the timing of our recently agreed price decrease. This is a World Class Vision, but there could be many others. A more common alternative is to have a formula based contract that delivers a competitive advantage to your business with price adjustments automated quarterly, but again, that is another topic. The next question is how we get there, which begins with having the right Purchasing Leader in place, doing a Gap Analysis, and then developing, executing and following up on our Strategy. Without diagnosing each individual business, it is impossible to say much about the Gap analysis. What I can say is that you want to avoid one-size fits-all programs. Instead, develop a custom plan that capitalizes on your business strengths, and improves its weaknesses, which is part of the cycle when striving for World Class status. World Class is not a destination that you arrive at and can stop but rather it is an ongoing process of Continuous Improvement. Our commodity strategies should be developed using Spend Segmentation (Figure 7) and be individually based within the strategic and critical groups. FIGURE 6 Decrease Price Hold Price Increase Price New volume 5,000,000 4,000,000 3,000,000 New Product Price $ 2.85 $ 3.00 $ 3.15 New Revenue $ 14,250,000 $ 12,000, 000 $ 9,450,000 New Product Cost $ 4,500,000 $ 4,200,000 $ 3,600,000 Profit Change $ (750,000) $ (1,050,000) $ (1,650,000) Figure 7 Spend Segmentation High Strategic In most cases, strategic materials represent a limited number of commoditites that comprise a large part of the company s spend. Spending Low Tail Spend Numerous small dollar products often utilizing distributors Critical Disruption risk high from limited number of suppliers,validity, major requalification costs Low Criticality High Source: ICIS Purchasing Advisory Service page 3 of 6

4 To do this, several things are required, like reliable Market Intelligence, Strategic Planning, Project Management / Execution skills and measures of performance. Let s first look at Market Intelligence. Often people think they cannot afford market intelligence. These are usually the companies that are classified as Easy in Figure 4. In reality, Market Ignorance can be far more expensive than Market Intelligence, especially on your strategic, critical, and larger volume purchases. Let s look at it analytically, as this is the decision making approach in Figure 8 that we need to be World Class. While your inputs will vary, the key in our example here is the bottom line Return of Investment (ROI). At a volume of about 200,000 units and up, Market Intelligence can be justified in this example. At 500,000 units, it is not only justified, it delivers a 233% return on the investment. The take-away from this hypothetical example is to not assume you cannot afford Market Intelligence; do the math. If you do not have the time or an Analyst to do these types of things, we have identified another gap that will need to be addressed; you clearly have Figure 1 issues (understaffed). There are four key pieces of Market Intelligence to have. 1. Market Pricing - essential to ensure you are consistently getting a fair price 2. Market News - reduces the risk of unfavorable surprises, especially on critical products. 3. Product Supply & Demand this is what determines whether it is a sellers or buyers market, which substantially affects our commodity strategy. Not realizing this could be costly, especially if your sole or primary source of market intelligence is your commodity sales person (fox watching the hen house?) 4. Product Forecast/Cost Models necessary for budgeting, prioritizing resources and best purchasing decisions. Multi-year decisions can be the most rewarding and the most costly, benefitting or paying for them year after year. What separates these two situations is market intelligence. Making high/low case scenarios with good forecasts are essential to making the best purchasing decisions and avoiding costly mistakes. For example: A new supplier offers a multi-year lower price contract for increased volume, which looks good to you, not realizing this market will soon be oversupplied and prices are expected to drop significantly. Without a good forecast this can happen. What you don t know can cost you. In forecasting, we teach a two-step approach (Figure 9). A feedstock, build up, cost driven component added to a supply & demand driven margin component. For this reason, having a good Feedstock Forecast and knowing the Supply & Demand status of your strategic and critical products is essential. For example: Market Intelligence Purchase Decision Matrix FIGURE 8 Cost of Subscription: $ 3,000 Annual product purchase volume that subcription is being purchased for Cents/lb savings from having market intellignece to get pay-back Annual Savings from 2 cents/lb of lower cost with market intelligence 100, , , , , $ (1,000) $ 1,000 $ 3,000 $ 5,000 $ 7,000 ROI (from investing in market intelligence) 33% 100% 167% 233% Source: ICIS Purchasing Adviosry Service Figure 9 Cost A function of feedstocks, varible and fixed cost Margin + = A function of Competition, i.e. supply & demand Price page 4 of 6

5 With all the new ethylene crackers coming on line in the US, supply will be long and margins are likely to be lower. As a seller, in our example above, the declining utilization (Figure 10) in our graph (that correlates highly to profitability), would suggest that I want to lock in my price for several years. As a buyer, I would want shortterm contracts, six to twelve months maximum, unless I was good at forecasting and could get a price that beats my best-case forecast scenario. While my Feedstock Forecast (cost driver), is important to budgeting, Supply & Demand drive margin and this is a better indicator of where future opportunities may exist for a Purchasing Professional. Let s face it, negotiating away cost increases when crude prices go up is less likely, but negotiating to avoid margin increases or for lower seller margins has a higher chance of success. Unfortunately, without good forecasting (and cost modeling) that uses Supply & Demand, we may not realize when seller margins are increasing and miss this opportunity. 70,000 60,000 50,000 40,000 Figure 10 Ethylene North America 99% 96% 93% 90% kt 30,000 20,000 10,000 87% 84% 81% Production Capacity Utilisation Source: ICIS Supply & Demand Dash Board 78% Figure 11 Deman vs Capacity Growth Curves Buyers Market Volume Sellers Market Capacity Demand Year page 5 of 6

6 Because Supply & Demand change differently, out of balance conditions occur. Demand increases at a relatively stable rate each year while supply increases in steps that typically takes years to happen (Figure 11). These out of balance conditions require that our commodity strategy be revised regularly to adjust for Buyer & Seller markets and the transition in between. Figure 12 shows a typical commodity cycle. Failure to execute at this level, leaves most companies in the perpetual sellers market mode, which is expensive. Unfortunately, this is just the tip of the iceberg and the topic of would take many more pages to complete. But if you would like more information on the ICIS Purchasing Advisory Service, contact James.Ray@ICIS.com. For information on our Advanced Purchasing Course, ICIS Forecasts, Pricing, News and other ICIS products, contact Jason.Bean@ ICIS.com. For Supply & Demand information, contact Beth.Daniel@ICIS.com Figure 11 Strategic Sourcing to insure a reliable supply at the lowest cost Most markets go through a cycle of: 1. tight, 2. balanced and 3. long supply Over years which affecdts your purchasing strategy Market Cycle Right now, PP is tight and growing tighter Balanced PP Market PE Market Long Market Balanced Tight PE on the other hand is slightly long and growing longer 3 10 year cycle For more information about ICIS Advanced Purchasing Course, please visit James Ray Senior Consultant, ICIS Having started on the shop floor and worked up through the ranks of the plastics industry, James Ray brings a unique blend of technical, managerial and analytical experience to his consulting role at ICIS. He has business advisory experience in the areas of benchmarking, operation cost modeling and activity based costing systems, planning, scheduling and project management, risk assessment, supply and demand analysis, alternate value streams and price forecasting. His purchasing advisory service has generated over 100 million dollars in client savings. Prior to working for ICIS, James worked for private industry (primarily Capital Management) in manufacturing, converting & recycling polymers for blow molding, extrusion and injection molding as well as textiles. His focus was on improving profitability by working smarter and employing strategies for reducing raw material costs using market intelligence and benchmarking, establishing raw material contracts and aligning with commercial contracts, eliminating waste via Lean Manufacturing and implementing process improvements using Six Sigma Methodology. James holds a degree in computer science from the University of Texas. page 6 of 6